Fiat Money

After China became the largest trading and mining market for bitcoin, China’s central bank is stepping up preparations for issuing its own fiat digital currency

By
NewsChina
Updated May.1

Two Papa John’s pizzas were sold for 10,000 bitcoins – then a trivial amount – to Laszlo Hanyecz, a programmer in Florida on May 22, 2010, just a year after the world’s first bitcoin was created. Holders of this virtual currency have much many choices than just pizza today. They can buy a Dell computer, subscribe to a pay-TV service by DISH, or book a hotel on the online travel agency Expedia. According to Coinbase, a digital currency platform based in San Francisco, 45,000 merchants accept bitcoin payment.

But all of this means little in the world’s largest consumption market, the largest e-commerce market and the largest bitcoin market: China. Bitcoin payment for goods and services was banned in China in 2014, after a brief adoption by some outlets of Taobao, Alibaba’s retailing platform.

Ninety percent of global bitcoin trading is done through Chinese bitcoin exchanges. China also leads the world in the mining, or production of new bitcoins. If Laszlo had chosen to keep his bitcoins, rather than eat them, he would have already become a millionaire by 2013 and a billionaire today, with the virtual currency worth around US$1,000 per coin – although the rate fluctuates wildly. This is largely thanks to the boom in the China market.

However, the prospects of bitcoin trading are likely to be dampened again by Chinese regulators’ recent checks of and warnings issued to major bitcoin exchanges. Regulators are concerned about financial stability – one of the top items on China’s economic agenda.

None of this means that Chinese regulators have zero interest in digital currencies. In January 2016 the People’s Bank of China (PBC) officially adopted a digital currency (fiat-based currencies are those not backed by precious metals or other commodities, but by government decree like most currencies) “as soon as possible,” and in September it published its own research on a possible roadmap to that end. At the end of January 2017, the currency was trialed on the central bank’s newly-built digital note trading platform, the first of its kind in the world, and a PBC-sponsored digital currency research institute will also be officially launched soon, according to the website of Shanghai Securities News – run by the official Xinhua News Agency – in early February. China would thus become the first economy using an officially-issued fiat digital currency – although other projects, such as Canada’s CAD-Coin, are also underway.

Technology for the Future?

Attacks against one of the nodes in the wider network do not change the information of the transactions, unless more than half of the nodes are attacked – currently believed to be almost impossible and undesirable due to the extremely high cost of doing so. Information on every transaction is accessible to all users in the network, but the information of the users making the deal is not. This combination of blockchain technology and cryptology, analysts say, ensures higher independence, security, efficiency and privacy than conventional financial service providers or monetary authorities. In Tech Trends 2017: the Kinetic Enterprise by Deloitte, an international tax firm, released in early February 2017, blockchain technology, the underlying technology of bitcoin, is described as the “gatekeeper of reputation and identity” in the emerging digital “trust economy” such as online services like Airbnb, a P2P accommodation platform.

However, bitcoin has faced questions about being a disruptive force since its beginning. The price of a bitcoin has been soaring fast and been extremely volatile, making many describe it as a bubble. A bitcoin was worth no more than a US dollar till April 2010. At the end of 2013, it was at one point more expensive than an ounce of gold. In stock or foreign exchange markets, changes of a few percent in a year are regarded as drastic. In the bitcoin world, the gap between its annual highs and lows reached staggering levels of hundreds of percent in the past few years. Regulators of major global economies have defined bitcoin as a financial tool, service or asset – making them liable for various taxes in some cases. Though existing bitcoins only carry about US$10 billion market value, regulators around the world are wary that the system could theoretically grow powerful enough one day to put the whole financial market at systematic risk.

Like cash, basic information on users, including their names, is not available to other trading parties. As a result, bitcoin can also be used for illicit purposes. The most notorious case was the Silk Road website, a marketplace where drugs, weapons, child pornography, and other illegal items were sold and settled in bitcoin. It was shut down by the US Federal Bureau of Investigation in October 2013. Several high-profile hackings of bitcoin trading platforms also caused huge losses to investors whose bitcoins were stolen, showing that the security of the technology is far from perfect despite the extravagant claims of its advocates.

Online Mining

China dominates bitcoin creation and trading, while bitcoin is more often used as a payment in the US and Europe. Mao Shihang, one of the first Chinese “miners” of bitcoins, now owns the world’s largest computing power run by tens of thousands of miners working for his F2pool, also referred to as Discus Fish, a “mining pool” where miners share resources and rewards. He has been dubbed a “magic fish.” He estimated that there are hundreds of thousands of such miners in China who hold 70 percent of the bitcoin computing power of the world. But just as with earlier “gold-mining” in online games such as World of Warcraft, the majority of such miners are employees, not entrepreneurs, living in workers’ dormitories near the cooled facilities that host the processing power needed, and often earning a relative pittance.

Between early 2016 and early 2017, bitcoin prices jumped by 300 percent. Mao Shihang thinks this is partly because of the limited supply of bitcoins and increasing cost of mining. Since June 2016, 1,800 bitcoins have been created each day, half of the 3,600 previously. As more, better computer networks are needed, the power cost of maintaining them has also more than tripled, Mao told NewsChina.

Bitcoin trading in China is eerily similar to other major investment tools there over the past few years, including real estate, stocks and bonds. The demand is driven by a lack of investment opportunities. The trading involves high leverage. Trading platforms charge investors for this service. The source of the fund is unclear and outside of regulatory scrutiny. Prices are susceptible to the whims of speculators and regulators.

In theory, it is easy to use bitcoin as a vehicle for averting China’s increasingly tight capital controls. An investor just buys bitcoins with the Chinese yuan on a Chinese bitcoin platform, transfers them to another site and cashes them out in US dollars on an overseas platform. Mao told NewsChina that the cost of foreign exchange rates and the long, strict procedure of identification required under US rules made the practice very expensive and difficult.

However, rocketing prices, high leverage without regulation and its potential as a capital flight channel are alarming enough in the eyes of regulators. The day after the bitcoin outvalued gold in December 2013, several Chinese ministers stated they would ban bitcoin payment for goods and services in the real world, and made it clear that bitcoin was not an acceptable currency. When bitcoin prices stood above US$1,000 in early January 2017, China’s central bank launched an investigation on why the trading volume and prices were so high on the three main Chinese bitcoin exchanges. The three platforms then declared they would stop providing fund-raising services, as well as ending free trading and cashing services for investors. In early February, nine other exchanges were warned by the central bank that they would be shut down if they were found to be involved in illicit acts such as leverage financing, money laundering or in breach of capital control. Bitcoin prices and trading volumes immediately fell after all these actions.

There are also concerns inside the Bitcoin community about the increasingly powerful role of Chinese miners. As transactions have been increasing, the speed of processing has slowed down. The debate on when and how much the block size should scale is even splitting the bitcoin world. Chinese miners dominating the computing power may have a decisive say on this issue once they reach consensus.

Mao Shihang remains confident about the prospects of bitcoin trading in China. “As China dominates mining and trading, a better-regulated market is good for the long-term development of the bitcoin business in China,” he said to NewsChina.

For Everyone?

“It is unfair to blame bitcoin itself. If judged by whether it is used for criminal purposes, the US dollar is definitely the most widely used by criminals,” noted research jointly released by the PBC School of Finance of Tsinghua University, leading bitcoin trading exchange huobi.com and sina.com in July.

While the legal controversies have added uncertainties to the future of bitcoin, its underlying blockchain technology has been warmly embraced by financial institutions and central banks in the world’s major developed and emerging economies. The People’s Bank of China began research on digital currency in 2014. In September issue of its magazine, China Finance, PBC officials published their views about the technical, legal and policy challenges and roadmap towards a fiat digital currency that could gradually replace the existing paper one and explain why the central bank wants a fiat digital currency. The strategy is a response to the potential shock towards the operation of the settlement system, the monetary system and the financial stability as a result of the inherent “anonymity, low-cost, cross-region, decentralization, high diffusion and high volatility” of digital currencies issued by private institutions. The limited, automatic supply of a digital currency also means little risk of inflation.

China enjoys “significant advantages” in issuing a digital fiat currency, the central bank’s articles add. China has already installed a digitalized financial infrastructure and China’s base of e-commerce users, the largest in the world, provides brisk demand for digital currency.

Blockchain technology is still in its infancy. The US and European startups of digital currencies and blockchain technology have received the most venture capital in this sector since 2012, but Chinese companies are catching up. Wanxiang, an auto parts giant based in Zhejiang Province, declared the world’s largest blockchain project in October 2016. It will invest more than US$30 billion to build a blockchain-based smart city in Hangzhou, the capital of Zhejiang, as well as support for blockchain research and startups from around the world. Joined by several other companies in finance and the Internet sector, Wanxiang has joined an initiative on blockchain architecture design led by China’s Ministry of Industry and Information Technology.

The PBC articles recognize the legal, financial and social challenges of replacing the paper fiat currency with a digital one. For example, it will involve the revision of the existing laws, which govern only paper fiat currency. It may hit the business of commercial banks as intermediaries of financial services and monetary policy. It will raise the question of how the currency can be exchanged with the fiat currencies of other countries in the process of the yuan’s internationalization. And users with little technological literacy, particularly low-income and poorly-educated groups, will find it difficult to use the digital currency and be further marginalized by the society.

All this shows that a fiat digital currency may be relatively close for Chinese users, but social preparation may be more important and difficult than the technical aspects of its creation.

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